Financial institutions could be involved in financial crime as victim, as perpetrator, or as instrumentality: financial institutions can be subject to different types of fraud or abuse; they can directly commit financial crimes; or they can be used by third parties to commit crime (International Monetary Fund, 2001a). Similarly, terrorism can have multiple implications for financial markets. First, as demonstrated by the attacks of 11 September 2001 on the World Trade Center financial markets can be, directly and indirectly, the victim of terrorism. Second, financial institutions can be specially set up to support terrorism. Third, financial institutions can be used, without their knowledge, to channel terrorist funds.
The present paper examines cases where financial markets became, directly or indirectly, the victim of terrorist acts, the consequences of those acts on the financial markets, and the policy and regulatory responses. Section 2 discusses some of the direct and indirect economic consequences of terrorism; Section 3 reviews the reaction of the financial markets to the 11 September 2001, terrorist attacks in New York, and 11 March 2004, attacks in Madrid; Section 4 examines the authorities' crisis management responses to the attacks on the financial markets considered; Section 5 examines the regulatory responses; and Section 6 concludes.
2 Economic consequences of terrorism
In recent years, terrorism has shown new patterns, shifting increasingly from military targets to civilian targets, including individuals and business activities. Figure 1 shows that business facilities have represented, by far, the preferred target of international terrorist attacks since 1998.
Recent terrorist attacks affected both the national and the global economy. The economic consequences can be largely broken down into short-term direct effects; medium-term confidence effects and longer-term productivity effects.
The direct economic costs of terrorism, including the destruction of life and property, responses to the emergency, restoration of the systems and the infrastructure affected, and the provision of temporary living assistance, are most pronounced in the immediate aftermath of the attacks and thus matter more in the short run. Direct economic costs are likely to be proportionate to the intensity of the attacks and the size and the characteristics of the economy affected. While the 11 September attacks on the United States caused major activity disruption, the direct economic damage was relatively small in relation to the size of the economy. The direct costs resulting from the terrorist attacks were estimated by the Organization for Economic Co-operation and Development at $27.2 billion ($14 billion for the private sector, $1.5 billion for the state and local government enterprises, $0.7 billion for the US federal government, and $11 billion for rescue and clean-up operations) (Bruck and Wickstrom, 2004), which represented only about 1/4 percent of the US annual GDP.
The indirect costs of terrorism can be significant and have the potential to affect the economy in the medium term by undermining consumer and investor confidence. A deterioration of confidence associated with an attack can reduce the incentive to spend as opposed to save, a process that can spread through the economy and the rest of the world through normal business cycle and trade channels. Likewise, falling investor confidence may trigger a generalized drop in asset prices and a flight to quality that increases the borrowing costs for riskier borrowers (International Monetary Fund, 2001b). The size and distribution of the effects over countries, sectors, and time would depend on a range of factors, including the nature of the attacks, the multiplier effects, the type of policies adopted in response to the attacks, and the resilience of the markets (Bruck and Wickstrom, 2004).
The 11 September attacks primarily affected the major industrial countries through a fall in demand generated by the loss in confidence about the economy and its impact on output. Emerging markets were affected by slowing external demand and a flight to quality in financial markets. Other developing countries may have been affected through commodity markets (International Monetary Fund, 2001b).
Despite having been the direct target of terrorism, which materially affected the market infrastructure and operations, following the 11 September attacks, the financial markets demonstrated resilience and a capacity to return to normalcy quickly (see below). This allowed the financial markets to perform one of their key functions: that of digesting the information on the economic and financial impact of the terrorist attacks after an initial shock and efficiently incorporating the information into asset prices so that it could be integrated into decisions about the future.
Financial instruments involve commitments over time and, therefore, price and provide a hedge against uncertainty. While the initial effect of any major crisis may involve a financial market overreaction because of higher levels of uncertainty, as the new information is being assessed and absorbed, once the long-term impact of the crisis is assessed, markets return to their pre-crisis condition. Thereafter, financial markets shift up or down according to investors' perceptions of how the crisis will be resolved (Taylor, 2004).
Finally, over the longer term, there is a question of whether the attacks can have a negative impact on productivity by raising the costs of transactions through increased security measures, higher insurance premiums, and the increased costs of financial and other counterterrorism regulations.
3 Impact of the terrorist attacks on financial markets
As noted above, financial markets have been directly and indirectly the victims of terrorist attacks. Striking at the core of the world's main financial center, the terrorist attacks of 11 September aimed at undermining the stability of the US and international financial system. In the aftermath of the attacks, the financial markets were not only confronted with major activity disruptions caused by the massive damage to property and communication systems, but also with soaring levels of uncertainty and market volatility.
Numerous key market players had substantial operations in or around the World Trade Center that were destroyed or damaged in the attacks, causing a widespread closure of the New York financial markets. Above all, the financial industry suffered a huge and tragic loss of life, accounting for over 74 percent of the total civilian casualties in the World Trade Center attacks (Lacker, 2004).
The biggest disruption to the trading infrastructure was caused by damage to the communications system of the world's largest custodian and settlement bank, the Bank of New York (International Monetary Fund, 2001b) Both Bank of New York and J.P. Morgan Chase, the two main clearing banks for government securities, had to relocate to backup sites as their main centers of operations were located just a few blocks from the World Trade Center (Lacker, 2004). Manual processing of securities and payment transactions resulted in significant delays in clearing and settlement, raising uncertainty about the completion of trades and demand for liquidity (International Monetary Fund, 2001b).
The government securities market was severely affected by the loss of the largest interdealer broker, Cantor Fitzgerald, and other smaller brokers whose offices were located in the World Trade Center (Lacker, 2004). While confronted with the impossibility of communicating by phone (the interdealer market operates by phone and screen-based trading systems) as phone contacts with brokers were disrupted, traders turned to online platforms, including BrokerTec, a consortium of primary dealers, and Cantor Fitzgerald's own eSpeed Inc., which was able to continue operating out of the firm's London offices (Lacker, 2004).
Other markets were affected as well. On the repo market, the initial incapacity to trade caused by damage to trading infrastructure, combined with the growing reluctance of market participants to lend out securities, resulted in a lack of supply that demanded immediate intervention by the authorities (International Monetary Fund, 2001b). Also, several federal funds brokers were disabled in the attacks, some ATM networks crashed entirely, and the facilities of the New York Board of Trade were destroyed (Lacker, 2004). Because of widespread disruption in the payment systems, many market participants became unable or unwilling to execute payments, causing a growing liquidity shortage.
A number of alarming signals prompted an immediate response by the Federal Reserve as discussed in the following section. First, the large buildup of Federal Reserve account balances ($120 billion – almost ten times the pre-11 September levels) was limited to a few banks, which meant that others were running huge negative positions and were in acute need of liquidity (Ferguson, 2003). Second, on 11 September, the number of transfers though the Federal Reserve's large-value electronic payment system (Fedwire) was down more than 40 percent and the total value was down 25 percent (Ferguson, 2003).
The insurance industry was also affected by large claims resulting from the attacks that generated losses estimated at more than $50 billion (PricewaterhouseCoopers, 2001). Further evidence, however, indicates that by and large insurers have suffered less as they were able to take advantage of the heightened uncertainty by raising premiums (International Monetary Fund, 2001b). In addition, some insurers were able to get exempted from paying some of the claims stemming from the attacks by using act-of-war clauses (Flynn, 2002).
On the capital markets, because of the timing of the attacks (around 9:00 a.m. eastern daylight time), the New York Stock Exchange and the NASDAQ Stock Market never opened for trading on 11 September. The US securities markets resumed trading on 17 September, following close consultations between the private sector and the Securities and Exchange Commission. The decision on when to reopen the markets took into consideration factors such as the safety of the personnel returning to work, and the viability of the infrastructure and communication systems[1].
In terms of market volatility, the US stock markets were down overall during the first day of trading and continued to drop in the following days. Between 17 and 21 September, Standard and Poor's 500 index fell by 11.6 percent (Figure 2) and NASDAQ index by 16.1 (International Monetary Fund, 2001b).
The impact of the 11 September attacks was visible worldwide on the major equity markets, which experienced sharp and rapid declines, demonstrating that market participants perceived the event as a global shock. The decline in the European stock markets, which started operating before the US markets were opened, was even greater after 17 September, because of spillover effects. All in all, the Dow Jones Euro STOXX index was down 17.3 percent between 11 and 21 September (Figure 3) (International Monetary Fund, 2001b).
In comparison with the impact of the 2001 terrorist attacks on the United States, the effects of the 11 March 2004, terrorist attacks on Spain were felt much less by the capital markets, and by the financial markets in general (Figures 2 and 3). In the euro area, the Dow Jones EURO STOXX fell by about 3 percent on 11 March, and continued to drop during the following days but recovered almost completely by the end of the month. Similarly, after a small decline, the Standard and Poor's 500 returned to the pre-11 March levels in less than a month.
Figures 2 and 3 demonstrate, however, that in the aftermath of both terrorist attacks investor confidence deteriorated beyond the national boundaries because of contagion effects. Likewise, in both cases the US markets seem to have suffered less and also recovered faster from the attacks, proving enhanced resilience. Nonetheless, once the initial shock passed, both markets bounced back within weeks to pre-11 September levels and generally continued to rise thereafter.
The differences in stock market behavior in the aftermath of the two episodes of terrorist attacks have several possible explanations. First, while the attacks in New York raised uncertainty about the stability of the global financial system, the attacks on Spain were perceived as mostly having a regional effect. Second, unlike the events of 11 September 2001, which occurred in the midst of a global economic downturn, the terrorist attacks in Madrid occurred at a time when the world economy was growing strongly (European Central Bank, 2004). The market uncertainty was even stronger in the first case as doubts raised about US capacity to drive the global economy out of recession.
Finally, the terrorist attacks in Madrid did not directly target the financial markets and, therefore, did not damage their infrastructure and communication systems. However, as noted above, despite major capital losses in the immediate aftermath of 11 September, most financial firms affected by the attacks were able to revert to backup sites and effectively resume their activity instantly or within days. The prompt intervention of the Federal Reserve in cooperation with other authorities also resolved the liquidity shortage and managed to maintain business and consumer confidence in the United States and abroad.
Further evidence on the impact of terrorism on financial markets is offered by a number of recent studies, confirming the observations above. Chen and Siems attempt to statistically test the significance of the 11 September attacks on global capital markets by measuring the deviation of index returns from their average (Chen and Siems, 2004). When the return deviation is large and statistically significant, the authors conclude that the market saw the events as important.
Table I shows the abnormal returns in the aftermath of the 11 September terrorist attacks for banking/financial sector indices from 14 global capital markets. As depicted in Table I, the event had a widespread negative impact on all the markets considered. Surprisingly, the impact was smaller on the US market, which displayed the least adverse abnormal returns 11 days after the attacks (11-day CAR), and also underwent the second fastest recovery. Chen and Siems also examine the financial markets' reaction in other periods of extreme risk aversion. They find evidence that US capital markets rebounded and stabilized quicker than other markets in the world following the 11 September attacks than in earlier periods when surprise terrorist/military attacks shocked global markets.
The authors find that one possible reason for the more limited impact of the terrorist attacks on the US markets (despite the fact that they were the actual terrorist target) stems from the Federal Reserve's accommodative policy, which was able to calm and stabilize the economy through the US banking/financial sector. Also, the authors find evidence that the increased market resilience can be at least partially explained by a banking/financial sector that provides adequate liquidity to promote market stability and stifle panic.
The main conclusion, however, is that financial markets were efficient in absorbing the shocks determined by terror attacks and continued to perform their functions in an effective way. A similar conclusion is reached by Eldor and Melnick in a study on how stock and foreign exchange markets react to terror (Eldor and Melnick, 2004). Referring to the 11 September attacks, SEC notes that “[The markets] did what they do best: they assessed, and responded to the crisis rationally. Unlike human beings, capital markets are capable of absorbing great shocks quickly”[1].
In terms of the lessons that can be drawn for the financial markets, at a general level, having diversified forms of risk intermediation makes the financial system more robust (Ferguson, 2003). At a practical level, the direct attacks on the financial sector of 11 September underlined the importance of having operative business continuity plans across the financial sector as a measure to counter the operational risk arising from severe activity disruption.
In the aftermath of the 11 September attacks, most of the financial firms directly affected by the attacks were able to relocate to backup sites and resume their operations within a short period of time. Thereafter, a large majority of the financial market players recognized that the preparations for Y2 K proved to be of value in the quite different context of 11 September. The serious consideration that the Y2 K issue received throughout the financial industry brought considerable improvement in the backup IT and communication systems helping market participants withstand the 11 September crisis (Ferguson, 2003).
4 Authorities' response
The 11 September terrorist attacks on the US financial system underscored the critical importance of the authorities' response in heading off systemic concerns. In the aftermath of the attacks, the Federal Reserve acknowledged that an immediate and firm policy response was key for restoring confidence within and outside the financial markets.
One of the first messages to transcend the chaos and panic of 11 September was that “[t]he Federal Reserve System is open and operating. The discount window is available to meet liquidity needs”. The Federal Reserve promptly deployed a wide range of instruments needed to provide sufficient liquidity, to ensure that the payment systems were operational, and to keep markets open (Ferguson, 2003).
The policy response of the Federal Reserve included unprecedented liquidity injections, estimated at more than $100 billion (Lacker, 2004). Liquidity instruments ranged from extensive discount window lending and open market operations to waiving overdraft fees and decreasing the intended federal funds and discount rates (for a comprehensive account of the Federal Reserve's action).
Moreover, to help foreign financial institutions cope with the liquidity shortage, the Federal Reserve arranged for the availability of reciprocal currency facilities of up to $80 billion though swaps with the European Central Bank and the Bank of England, and raised the ceiling of a preexisting swap with the Bank of Canada.
In addition, various steps were taken to render market mechanisms and systems operative. Although the US airspace was closed for several days after the attacks, preventing the timely collection of checks by their home bank, the Federal Reserve continued to provide credit for checks on the usual availability schedules (Ferguson, 2003). Likewise, the Federal Reserve encouraged state member banks and bank holding companies to work flexibly with customers affected by the disaster and contact their regulator to discuss ways to respond to the distress (Ferguson, 2003).
However, ensuring the financial markets' return to normalcy required more than the Federal Reserve's quick and efficient action. Close cooperation and coordination with other domestic and foreign authorities was necessary. The US Securities and Exchange Commission helped the markets overcome the crisis by relaxing trading rules on securities lending and share repurchases (International Monetary Fund, 2001b). Similar to the Federal Reserve, the Securities and Exchange Commission left the communication channels open and kept the public fully and timely advised[1].
Also, while the monetary and financial authorities focused on maintaining financial stability, other government agencies took the initiative to introduce fiscal stimulus to bail out industries affected by the attacks. The insurance and airline industries received direct government assistance in the immediate wake of the attacks. The US administration and the Congress announced their intention to act as an “insurer of last resort” to cover claims that private insurance companies could not or would not pay (Flynn, 2002). A year after the attacks of 11 September, a “Terrorism Risk Insurance Act” was passed, providing for a transparent system of shared public and private compensation for insured losses resulting from acts of terrorism.
In the short and medium terms, more economic stimulus was needed to help the economy recover as the recession deepened further after the terrorist attacks. The global slowdown that had started most prominently in the US in 2000 had, by mid-2001, become a synchronized downturn across all major regions of the world, leaving them particularly vulnerable to a negative impulse (International Monetary Fund, 2001b). The Federal Reserve continued to lower the targeted federal funds and discount rates in the following weeks an additional 1.25 points. Further downward adjustments followed in 2002 and 2003 (Figure 4). Also, expansionary fiscal policies have been implemented to help the economy recover.
At the international level, a coordinated effort was made to support the global payments system, strengthen confidence, and shore up financial markets. Monetary authorities from major economies such as Canada, the euro area, Japan, Switzerland, and the United Kingdom directly injected large amounts of liquidity and made immediate interest rates cuts in response to the Federal Reserve's measures (International Monetary Fund, 2001b). These actions were subsequently followed by a number of other economies, including Denmark, Hong Kong SAR, Korea, New Zealand, and Sweden (International Monetary Fund, 2001b).
Within a short period of time of the attacks in New York, a majority of countries stepped up the fight against terrorism in an effort to maintain international peace and security. Further actions were taken globally in the fight against terrorism and terrorism financing, as discussed in the next section.
In contrast with the wide range of monetary, financial, and fiscal measures undertaken at the national and international levels in the aftermath of the 11 September attacks in New York, the terrorist attacks that took place in Madrid, on 11 March 2004, called for little economic policy response. While the human loss was equally tragic, the effects of the terrorist attacks on the Spanish and global financial markets were rather muted and, therefore, no special intervention was required (European Central Bank, 2004).
The European Central Bank, the monetary authority of the euro area, which includes Spain, announced on 1 April 2004, that the main intervention rates (minimum bid rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility) were to remain unchanged (European Central Bank, 2004). Also, in a period of strong economic recovery, no fiscal stimulus or other economic measures were deemed necessary, other than providing aid to victims and facilities directly struck by the terrorist attack.
The dramatic episodes depicted above underscore a number of key lessons related to financial crisis containment. First, the experience underlined the importance of the central bank's role in safeguarding the stability of the financial system during crisis. From acting as a lender of last resort, to maintaining an open and transparent dialogue with the regulated entities, the Federal Reserve played a paramount role in restoring the markets' confidence and helping them perform their functions.
Of particular importance in this context was the role of the Federal Reserve as lender of last resort (Ferguson, 2003). Past experience has shown that deposit insurance or suspension of payments are neither necessary nor sufficient to prevent banking crises. The Federal Reserve's prompt action as a lender of last resort in the aftermath of the 11 September attacks events allowed banks to manage the acute liquidity shortage, and to prevent public panic and possible bank runs.
A second key lesson was the critical importance of cooperation and coordination among domestic authorities and across borders. In the US markets, there was synchronized action by the US regulatory community and other stakeholders that allowed markets to return to normal functioning quickly and effectively (Ferguson, 2003). Some of these actions included non-traditional emergency measures. Both the Federal Reserve and the Securities and Exchange Commission waived the observance of a number of rules by the regulated entities and offered their expertise in helping them overcome the distress caused by the attacks. As noted above, the coordination extended internationally, as key central banks stood ready to intervene to provide the necessary liquidity to support the payments system. The timely provision of liquidity by central banks and the relatively healthier position of financial intermediaries were instrumental in containing financial contagion across industrial and emerging markets and across asset classes.
5 Regulatory perspective
Besides providing timely and effective support as needed in the aftermath of terrorist attacks, the financial markets' authorities have to undertake preventive measures on an ongoing basis. Namely, from a regulatory standpoint, the impact of terrorism on financial markets raises two challenges: first, capturing the possibility for terrorist events from an operational risk perspective; and, second, developing an adequate framework for countering terrorist financing.
